A Debt Deferred

Is the credit crisis ancient history, or was 2009 merely a stay of execution? Joe Ragan, CFO of Boart Longyear, hopes that it's the former. The Salt Lake City–based finance chief spent 80 nights in Sydney last year in an effort to recapitalize the Australia-listed drilling-services and mining-equipment company. Its revenue had fallen so low that analysts predicted a breach in debt covenants, and its stock traded at liquidation value. By November, Boart Longyear had deleveraged by more than 90%, but only by issuing a large amount of new equity, more than doubling the number of shares already outstanding.

Unfortunately, for many highly leveraged businesses the credit crisis is far from over. Although the default rate of bond-issuing corporations is projected to drop by half (to about 7% in 2010, according to Fitch Ratings), there is also evidence that many CFOs will have to renegotiate with creditors this year. They may not be as successful the second time around.

The credit default swap (CDS) market is pricing in expectation of more corporate defaults. The Baird CDS Index, an index of 36 CDS contracts for non-investment-grade debt, dropped throughout 2009 but remains six times its base level of January 31, 2006. "We're not out of the woods," says William Welnhofer, a managing director of investment banking at Robert W. Baird & Co.

One reason for pessimism is the prevalence of distressed-debt exchanges in 2009 as a "cure." More than 100 issuers bought back or exchanged for equity billions of dollars of bonds at steep discounts, according to Standard & Poor's, compared with only 70 issuers that filed for bankruptcy. But bond exchanges, which count as a default, don't wipe the balance sheet as clean of debt as bankruptcy does, according to studies by Fitch Ratings.

Indeed, even after a debt exchange, companies like Freescale Semiconductor, McClatchy, and Harrah's Entertainment are still rated CCC, says Mariarosa Verde, a managing director at Fitch Credit Market Research. CIT Group and Six Flags conducted distressed-debt exchanges in 2009, only to declare bankruptcy later on.

Additionally, about $163 billion of speculative-grade debt will need to be refinanced in 2010, with greater amounts maturing between 2011 and 2014. "A concern in 2010 is not only the risk of new defaults but also a heightened risk of serial defaults," Verde says. "If growth proves weak, some of the debt-restructuring measures adopted over the past year may have been successful only in helping companies defer, rather than avoid, bankruptcy."

Giving GroundIt may sound odd, given the tougher lending criteria of banks, but in some cases lenders are bending over backwards to keep borrowers in business.

For example, following a $538 million debt-exchange offer, lenders of YRC Worldwide agreed to defer nearly all interest and fees and let the trucking company access a revolver reserve. (YRC hasn't posted a quarterly profit since 2006.) Similarly, creditors of Broder Bros., a distributor of corporate apparel, agreed to waive defaults relating to a delay of the company's 2008 audited financial statements and nonpayment of monthly interest. (Broder has a shareholders' deficit.) And at press time, Freescale Semiconductor was seeking permission from its banks to sell extra debt to repay its loans — despite already having more than $7 billion of high-yield bonds and loans on its books.

Some turnaround experts say that banks are not being aggressive enough in dealing with their distressed-loan portfolios, often due to an unwillingness to book loan losses or a lack of necessary capital to absorb them. "It's called 'lend and pretend,'" says Richard Lindenmuth, a managing director at Boulder International. "One bank told me it hasn't done a workout in eight months. In this economy that's not [just] abnormal, that's a fantasy."

Most banks don't want to force the hand of companies that are in need of liquidity, says Dirk Hobgood, CFO of Accretive Solutions, a turnaround consultancy and executive-search firm. "Banks want to get to the point of being made whole, until [maybe] an acquiring company comes along to infuse more capital," he explains. "If you write off the debt, you may not get to play a part in the positive reemergence of the company when the economy improves."

But banks won't wait forever. While many credit agreements were stuck in neutral last year, 2010 will be a year of action for banks, predicts Hobgood. "You don't typically restructure into a definitive credit agreement or capital structure if you don't know what the future holds," he says. Banks will eventually want to liquidate or find another way to "true up" their positions, Hobgood adds. "We're going to see a lot more restructurings this year."

To the RescuePositive developments in other capital markets — namely, record-setting high-yield issuance in the second half of the year (see the chart above) and the rejuvenated stock markets — helped bail out many distressed companies in 2009.

Take ProLogis, a Denver-based real estate investment trust (REIT) that invests in warehouse space. Its corporate debt had been downgraded in late 2008, and its $3.8 billion global line of credit was scheduled to mature in 2009. The firm came up with a comprehensive restructuring plan: sell aging properties, buy back bonds, issue equity, and renegotiate the revolver. ProLogis earned a 20% return by purchasing $1.4 billion of bonds, but the banks played hardball when the firm sought to redo a bank deal before selling new shares.

"The constraints or handcuffs that were going to be put on the term sheet were going to be very limiting," says Bill Sullivan, ProLogis's finance chief. "So we said, 'Let's reverse this — let's bite the bullet and issue equity.'" The result: less-onerous covenants on the line of credit. But ProLogis also had to issue shares equal to 58% of its outstanding float at $6.60 per share, less than half of what the stock traded for four months earlier. "It was a tough pill to swallow," admits Sullivan. But the restructuring unburdened the REIT's debt load by $3 billion.

When Boart Longyear lost 50% of its revenue after the banking crisis hit, half of its 16-member bank syndicate started to move it into workout mode, says CFO Ragan. "The relationship managers were no longer the primary contact," Ragan says. "The workout guys are tough; they're looking at net realizable value."

Debt DelightThe explosion of the high-yield bond market that allowed even some CCC-rated companies to raise new money also aided companies in staving off bankruptcy or liquidation in 2009. But did these companies just kick the can down the road?

Perhaps. According to Eric Goodison, a partner with Paul, Weiss, Rifkind, Wharton & Garrison, the high-yield market's comeback was partly due to supply and demand. "There's a huge infrastructure in place to invest in the debt marketplace, and we've had two years of reduced levels [of issuance]. So even with 30% to 40% less capital available, there are still large dollars to deploy."

On the other hand, adds Goodison, "I don't think we're in some sort of bubble where people are doing silly or stupid deals." Investment managers, after all, perform due diligence on a new issue, which can include asset-coverage metrics, cash-flow generation, and "what-if" analyses. More important, "we're not seeing deals where leverage is seven, eight, nine times; we're seeing deals where the companies are three, four, and five times leveraged," says Goodison.

Some bond analysts say that covenants in this new round of high-yield issuance are too lenient. Buried in new bond indentures are a robust set of covenant changes to promote borrower flexibility, says Chris Taggert of research firm CreditSights. But Goodison says that on a relative basis, covenants have improved. Before the banking crisis, carve-outs from covenants such as limits on incurring other debt had softened. The definition of EBITDA (earnings before interest, tax, depreciation, and amortization), for example, became a lot looser because companies were permitted "add-backs." As the [credit] market returned, covenants tightened, but some of the holes remained. "But the things most egregious to the buy-side market — like EBITDA add-backs — are not finding their way into current deals," says Goodison.

To obtain desirable pricing on $950 million in unsecured bonds, ProLogis had to unify its covenants across six separate sets of notes. Leverage covenants in the company's bonds had five different definitions of total asset value, says CFO Sullivan. Some covenants used the total assets number given on the balance sheet, but others factored in accumulated appreciation minus intangibles, he says. Still others capitalized and valued the income stream from the company's investment-management business. "It was crazy," Sullivan says. "People could read the covenants, but they couldn't calculate them."

Delayed Reckoning?So, will the debt and equity markets be as forgiving to leveraged companies in 2010, or will many firms simply be unable to find relief from crushing debt loads coming due?

Companies that haven't deleveraged yet are hoping that two things will happen, says attorney Goodison: that their businesses will turn around so that EBITDA rises, thus reducing leverage ratios, and that debt markets will come back, enabling companies to finance at higher leverage multiples. "Then the gap to solve the problem may become much more manageable — or maybe not," Goodison says.

Even though some CFOs have been criticized for delaying the day of reckoning with various financing strategies, there aren't many alternatives. "The only thing that provides a complete solution now is bankruptcy, and if you're trying to stay out of bankruptcy — and you should want to — you have to take the opportunity [that the markets give you]," Goodison says.

ProLogis and Boart Longyear expect business to recover this year. Boart Longyear is forecasting 15% year-on-year revenue growth in 2010, assuming global economic recovery, no significant drops in commodity prices, and continued improvement in the financing markets. ProLogis management says market fundamentals are in their favor, and leasing activity for warehouse space was on the uptick in the second half of 2009.

Says ProLogis's Sullivan: "I don't lose a wink of sleep thinking about 2012 and 2013 maturities, because I'm confident that if the capital markets remain open and active in any way, shape, or form, we'll have access to capital — and plenty of it." Many other CFOs may feel that a good night's sleep remains a dream deferred.